The Federal Budget Grant Distribution Formula and the Solidarity Principle of the Ethiopian Federal Democratic Republic

Dr. Petra Zimmermann-Steinhart

1.         Introduction

In May 2009, the House of Federation endorsed a new Grant Formula to equalize fiscal imbalances between the federal level of government on one hand and fiscal imbalances on the regional level of government on the other hand. This article analyses the relationship between the new grant formula and the solidarity principle enshrined in the Ethiopian Constitution.

In doing so, the article focuses on the principles of the formula rather than looking into the details of the econometric calculation. The objective of this article is to see if and how the formula responds to the requirements deriving from the solidarity principle set up by the Ethiopian Constitution. The article sets out the equality and solidarity principle of the constitution and contrasts it with the principles of the New Budget Grant Distribution Formula.

Chapter two summarizes the different aspects of the equality and solidarity principles of the Ethiopian Constitution in order to set out criteria regarding for the further discussion. Chapter three outlines basic principles of fiscal equalization and compares the formula and its different aspects against the criteria found in chapter two. Based on the previous two chapters, the last section responds to the question whether the new Federal Budget Grant Formula meets the constitutional requirements of the solidarity principle.

2.         The Principles of Equality and Solidarity in the Ethiopian Constitution

The organizational principles of federal states can either base on the competition between the constituent units (e.g., regions) or on the basis of solidarity among these units and the federal level of government. In competitive systems, the assumption prevails that the governments of the constituent units are responsible for the development within their jurisdiction, which will then result in economically, socially and politically diversified states. This assumption is often joined by a second assumption, claiming that (economic and/or political) competition among the constituent units leads to an overall growth and better living conditions. This is based on the idea that because people and investors will rationally choose the best possible environment, all constituent units will strive for the provision of such environments. The classic positive view towards regional competition was expressed in 1932 by an US-American Supreme Court Judge, Louis Dembitz Brandeis stating: “It is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory, and try novel social and economic experiments without risk to the rest of the country” (quoted in Tarr 2001: 40).

As opposed to this view, the solidarity principle is focusing on a stronger co-operation between the federal and the sub-national governments on one side and between the sub-national governments on the other side in order to achieve equal or at least comparable living conditions across the whole country. This implies a responsibility to support weaker parts of the federation either through the federal government only or through direct support of the weaker units through the stronger ones.

The constitution of the Federal Democratic Republic of Ethiopia is based on the voluntary commitment of the Ethiopian Nations, Nationalities and Peoples to build a political community which ensures lasting peace, economic and social development through mutual support and mutual respect (Constitution of the FDRE 1995: Preamble). The Preamble of the Ethiopian Constitution implies that the goals of lasting peace, the rule of law, democratic order and a sustainable economic development can only be achieved through equality, mutual respect and support by rectifying past injustices. This statement builds the foundation of the equality and solidarity principles which find further expressions throughout the constitution.

The equality principle is manifested throughout all chapters of the constitution. It refers to equal rights and opportunities for individuals regardless of their sex, age, religious affiliation and to the equal status of all Nations, Nationalities and Peoples. Instead of listing all occurrences, only those relevant for fiscal transfer systems shall be listed here: Article 39 (3) grants the right of self-government to all Nations and Nationalities including the establishment of the necessary institutions, which has wide implications on administrative costs. Article 41 (3) grants the right to equal access to public funded social services, Article 89 (2) obliges the government to provide equal opportunities to improve their economic conditions to all Ethiopians. Additionally this sub-article requires the government to promote an equitable distribution of wealth among Ethiopians. Article 90 (1) refers to the provision of access to public health services, education, clean water, housing, food and social security to all Ethiopians.

The above mentioned equality principle builds the foundation of the solidarity principle. The solidarity principle itself finds one major direct expression in Article 89 (4) which reads: “Government shall provide special assistance to Nations, Nationalities, and Peoples least advantaged in economic and social development.” The requirements set out here build the basis of affirmative action leading to the achievement of guaranteeing equal chances throughout the country. The implementation of Article 89 (4) has implications with regard to policies on the federal as well as the regional level of government. Providing least advantaged Nations, Nationalities and Peoples with special assistance in order to close the gap to others, ultimately leads into additional spending. The following section will analyze in how far the new Federal Budget Grant Distribution Formula accommodates these requirements and implications.

3.         General Equalization Mechanisms

3.1 Vertical and horizontal Equalization

The principle or paradigm according to which a particular political system is organized usually has implications for the way fiscal equalization is achieved. Generally speaking, there are two types of fiscal equalization: Fiscal equalization becomes necessary, when the revenue of a level of government or administration does not fit the spending needs of this level. In federal states world-wide, it is usually the federal government which is creating/raising a higher revenue than it needs to carry out its mandates while the sub-national level of government (regions) raise a far lower level of income than they would need to cover their needs. This situation is called vertical fiscal imbalance and is addressed through vertical fiscal equalization mechanisms. Vertical fiscal imbalances are equalized in both, federations based on competition and on federations based on solidarity.

Besides the vertical imbalance, we also find horizontal imbalances. This is the case if regional states vary significantly in their revenue raising capacity and/or their spending needs. Whether these imbalances are balanced or not, is very much a question of the type of federalism in place. If the federation is based on a competitive relationship between the regions, horizontal equalization is not likely to be applied. The underlying assumption here is that the regions are responsible for their income and spending, so only the vertical gaps will be addressed.

In cases of federations building upon solidarity, equalization of horizontal imbalances is far more likely than in those applying competitive models. Principally, horizontal imbalances can be reduced through two different ways:

1)      By equalizing regional revenues through transfers from financially strong regions to financially weak regions: A share of the revenue of those regional states having raised a revenue which is significantly above the average of the revenue raised by all regional states is transferred to those regional states having raised a revenue significantly below the average. In order to achieve this, the margins need to be defined and calculated and a formula for the distribution needs to be set up. This process tends to be a sensitive and controversial issue within federations. An example where this method is applied – and contested (in combination with measures to reduce vertical and horizontal imbalances through funds of the federal government) is Germany (Jochimsen 2008). In the German case, the goal is to achieve comparable living conditions across the German Laender.

2)      By transfers provided by the federal government going beyond simply addressing vertical imbalances. In this case, the actual revenue raised by regional governments is not taken into account and the balancing is based on the capacity to raise revenue. The goal is not to equalize the budgets of the regional states, but to equalize uneven capacities to provide services (see also Rangarajan 2004; Zimmermann-Steinhart 2008).

The following section will demonstrate the mechanisms applied by the new Federal Budget Grant Distribution Formula.

 

3.2 Main Characteristics of the new Federal Budget Grant Distribution Formula

One of the requirements of the new Federal Budget Grant Distribution Formula was to be effort neutral, i.e., it should not be affected by regional government policies and it should not affect the behavior of regional governments. This is designed to avoid negative impacts of the formula. One negative impact could arise if regional states are punished for raising revenue above their capacity deducting this additional revenue from the share the region gets. Deducting this higher revenue would mean that the region will remain with the same level of revenue, whether it is active in improving its income base or not. This again means that the region would not have any incentive to increase its own revenue.

The formula has been designed in a highly participative process between representatives of the regional executives and legislatives, including experts as well as political representatives. Additionally to joint meetings with experts of and contracted by the House of Federation, field trips have been undertaken to analyze the situation in each regional state to complement data derived from the Central Statistics Agency (House of Federation 2009).

The new Federal Budget Grant Distribution Formula adopted by the House of Federation on May 15, 2009 combines mechanisms of balancing vertical and horizontal imbalances. It builds on three main pillars:

1)      Balancing differences in revenue raising capacities;

2)      Balancing differences regarding expenditure needs;

3)      Reserving one percent of the distribution pool for Benishangul-Gumuz, Afar, Gambela and Somali Regional States, the four so-called emerging regions requiring special attention.

 

Revenue Raising Capacities

For the estimation of the revenue capacities (revenue potentials), those sources (taxes) building the main regional revenue have been included. These taxes/fees are:

·      Personal income tax

·      Business profit tax

·      VAT

·      Agricultural income tax

·      Rural and land use fee

·      Sales tax (TOT)

·      Fees for medical supply and treatment

The accumulation of these taxes accounts for 80 percent or more of the regional revenues on average. In order to calculate the potentials for these taxes, different approaches depending on the nature of the tax and data availability have been used. While data on Personal Income Tax is easily accessible, other data proved more difficult to be computed (for details see House of Federation 2009: 13-22). After the potential revenues from the individual taxes were computed for each region, the revenues have been aggregated. As a next step, the aggregated potential revenue was compared to the actual revenue collected by the regions. For this calculation the average revenue of three years has been used. The comparison leads to a ratio between actual and potential revenue for each regional state. This ratio has been averaged across all regional states. The ratio is 48.53 percent and has been used as deflator to calculate the effective aggregate potential revenue used for the formula. The result of this operation is shown in Table 1:

Table 1: Effective Potential Revenues

Region

Effective potential revenue in Mio Birr

percentage of effective potential revenue of the national potential revenue

Tigray

110.64

9.95

Afar

14.29

1.29

Amhara

245.29

22.07

Oromiya

455.33

40.96

Somali RS

27.84

2.50

Benishangul-Gumuz

17.24

1.55

SNNPR

201.62

18.14

Gambella

9.99

0.90

Harari

12.71

1.14

Dire Dawa

16.58

1.49

National Total

1,111.53

100.00

Source: (House of Federation 2009: 23)

 

 

Expenditure Needs

Similarly to the calculation of the revenue potential, the expenditure needs have been calculated based on indicators accumulating to more than 90 percent of regional expenditures based on constitutional mandates and implementation of national policies. These indicators are:

·      General administration costs

·      Education

·      Public health

·      Agriculture and natural resources

·      Clean water supply

·      Rural road construction and maintenance

·      Micro and small scale enterprise development

·      Work and urban development

The results of the calculations are shown in Table 2.

Table 2: Expenditure Needs

Region

Total expenditure need, partially adjusted for spatial price variations in Mio Birr

Tigray

2,313.82

Afar

999.70

Amhara

7,546.74

Oromiya

10,635.70

Somali RS

2,535.10

Benishangul-Gumuz

538.85

SNNPR

6,428.82

Gambella

464.86

Harari

291.46

Dire Dawa

332.98

National Total

32,088.04

Source: (House of Federation 2009: 42)

 

 

 

Special Attention to Emerging Regions

Four out of the nine Ethiopian regional states, Afar, Benishangul-Gumuz, Gambella and Somali Regional State, have significantly lower revenue raising capacities and higher expenditure needs than the rest of the regions. This is a function of policies of former Ethiopian regimes. Similar to equalization mechanisms in other solidarity-based federations or systems, like Germany or the European Union (Jacoby 2008; Jochimsen 2008), it is also assumed here, that the four emerging regions would not be able to catch up with the rest of the region. In order to address this inequality, one percent out of the total grant is reserved for the four emerging regions.

The share out of this reserved part of the total budget grant is again computed on the basis of weighted indicators relating to the particular situation of these four regional states. The indicators used are shown in Table 3.

 

Table 3: Indicators and distribution of special funds to the emerging regions

Indicator

Weight

Afar

Somali

B.-G.

Gambela

Area of cultivated land (in hectares)

0.2

 

 

 

 

Population

0.1

 

 

 

 

Tropical livestock unit

0.15

 

 

 

 

Urban unemployment

0.1

 

 

 

 

Spatial price index

0.15

 

 

 

 

Tax raising effort

0.2

 

 

 

 

Number of poor people

0.1

 

 

 

 

Share among regions

1

18.61

42.48

28.87

10.3

Source: (House of Federation 2009: 45)

 

 

 

 

 

Table 3 also shows the distribution of the one percent share across the four emerging regions based on their distinct development situation.

 

Summary

Vertical imbalances are defined as the gap between the revenue raising capacity of a government and the expenditures this government has to make in order to fulfill its constitutional mandates and duties and / or to implement policies of the federal level of government. These imbalances result from a usually lower capacity to raise revenue of the sub-national level. In order to reduce these imbalances, equalization mechanisms, i.e., fiscal transfers from the federal to regional level are applied. Whether this is done by addressing either expenditure needs or revenue needs only or by a combination of both factors, depends on the political choice and the socio-economic context of a given country.

In order to reduce the vertical balance, the new Ethiopian Budget Grant Distribution Formula considers both sides: the expenditure needs and the revenue raising capacities because of the heterogeneous composition of the regional states and their development needs. This approach enables the regional states to discharge their constitutional mandates and to meet the constitutional requirement of access to equal services across the country.

These two steps, however, do not touch the relatively worse situation of the four emerging regions. Using the general distribution through the first two pillars of the formula would make it extremely difficult for these regions to provide the necessary services and to undertake the prescribed investments. Therefore, the formula applies a third step. Dividing the overall amount of the Budget Distribution Grant into a 99 percent share, which is divided according to the principles of vertical fiscal equalization, and a one percent share, which is reserved for the four emerging regional states, includes an element of horizontal equalization into the formula.

4.         Conclusion: The New Budget Grant Distribution Formula Meets the Equality and Solidarity Principle

The question underlying this article is whether the new Federal Budget Grant Distribution Formula meets the requirements of the equality and solidarity principle of the Ethiopian Constitution. These two principles basically state the right of equitable development, equal access to services and a special assistance to those Nations, Nationalities and Peoples who have been least advantaged throughout history.

As has been shown above, the new Federal Budget Grant Distribution Formula enables the regional states to carry out their constitutional mandates. The vertical imbalance emanating from the lower capacity of raising revenue of regional states in comparison to the federal government is addressed through the first two pillars of the formula: the equalization of the revenue raising capacities and the expenditure needs. In order to equalize these two elements, 99 percent of the overall Budget Distribution Grant is used. The horizontal imbalance between the four emerging regions, Benishangul-Gumuz, Afar, Gambela and Somali regional states and the rest of the regional states is equalized through a share of one percent of the overall Budget Grant which is divided among those four regions in addition to their share out of the 99 percent allocation.

The combination of the two equalization steps, vertical and horizontal equalization addresses both, the equality and the solidarity principles. The equality principle is met because all regional states are enabled to provide the constitutionally granted services and access to resources on an equal base: the regions in higher need for more investments gain a higher share of the funds because they have higher expenditure needs.

 

Table 4: Shares vertical / vertical and horizontal equalization

Region

Share of regions vertical equalization only

 in percent

Share of regions after vertical and horizontal equalization

in percent

Tigray

7.11

7.04

Afar

3.18

3.34

Amhara

23.57

23.33

Oromiya

32.86

32.53

Somali RS

8.09

8.43

Benishangul-Gumuz

1.68

1.96

SNNPR

20.1

19.9

Gambella

1.47

1.57

Harari

0.9

0.89

Dire Dawa

1.02

1.01

National Total

100

100

Source: (House of Federation 2009: 47)

 

Table 4 highlights the differences in the shares of the regional states with and without the application of the horizontal equalization. Reserving a one percent share for the emerging regions leads to a reduced share of all other regions and a higher share of the emerging regions in comparison to a purely vertical equalization. In federations, where the federal transfers are decided by federal institutions without involvement of the beneficiaries, the application of this formula would have come with only little surprise although it is common knowledge that any equalization formula is usually contested within the country it is applied. The situation in Ethiopian bears an additional feature. The formula has been prepared and decided by representatives of the beneficiaries. The decision to apply a model including both, horizontal and vertical equalization was taken unanimously after a series of consultation processes with representatives of all regions. This unanimous decision is quite remarkable and not self-evident, especially not in a situation, where even the relatively better-off regional states have nothing to spare. And still, these relatively stronger regions did agree to reduce the amount of funds distributed among them by one percent. This is a strong expression of solidarity!

Therefore it can be concluded that the New Budget Grant Distribution Formula not only addresses the equality principle, but also the solidarity principle stated in the Ethiopian Constitution.

5.        Literature quoted

House of Federation. 2009. "The New Federal Budget Grant Distribution Formula." Addis Ababa: House of Federation.

Jacoby, Wade. 2008. "Side Payments over Solidarity: Financing the Poor Cousins in Germany and the EU." German Politics 17:470 - 487.

Jochimsen, Beate. 2008. "Fiscal Federalism in Germany: Problems, Proposals and Chances for Fundamental Reforms." German Politics 17:541 - 558.

Rangarajan, C. 2004. "Fiscal Federalism: Some Current Concerns." in Indian Journal of Federal Studies. New Delhi: Center for Federal Studies, Hamdar University.

Tarr, G. Alan. 2001. "Laboratories of Democracy? Brandeis, Federalism, and Scientific Management." Publius: The Journal of Federalism 31:37-46.

Zimmermann-Steinhart, Petra. 2008. "Fiscal Equalization Systems: Australia and Ethiopia." Yefederation Demets 4:55-60.